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Flip Side of a Currency Union

Category : NISM-Currency Derivatives

The travails of the weaker economies within the Euro zone have shown the disadvantages of joining a currency union…

Source: Value Research Online

The sovereign debt crisis of South European countries intensified once again in September. There is widespread fear within markets that Greece may default. The troubles of these peripheral European nations have once again raised questions about the wisdom of having currency unions. It is not my contention that the currency union within Europe was a bad idea per se. By removing nominal exchange rate risk for trading partners and reducing transaction costs, such unions promote trade among member countries. But the implementation of the European currency union was flawed from the beginning.

Moreover, the peripheral European nations, while enjoying the benefits of such a union, behaved in an irresponsible and profligate manner. Now it is payback time. And now that they are in trouble, the biggest disadvantage of a currency union, the lack of an independent monetary policy, will prevent them from finding their way out of the hole that they have dug for themselves.

Treaty obligations ignored

The Maastricht Treaty of 1992 had laid down certain preconditions for the countries joining the currency union. One, they had to ensure that their annual rate of inflation was not above 1.5 per cent. Two, they had to contain the budget deficit at below 3 per cent of GDP. And three, they had to maintain a debt-to-GDP ratio of less than 60 per cent.
At the time of formation of the union, many countries were allowed to join it despite not meeting these conditions. Subsequently these criteria were not strictly enforced. To meet them the weaker economies would have had to reduce their public spending and raise taxes. This they were reluctant to do as their politicians were not willing to impose the period of fiscal austerity that it would have entailed.

Profligate ways

Before joining the union, the peripheral economies were required to pay a much higher rate of interest on external borrowings than, say, Germany. But once they joined the European monetary union, the interest rates they were required to pay fell sharply. Private lenders reckoned that now that these economies had joined a monetary union, the value of loans made to them could no longer be eroded through currency depreciation. So the currency risk premium they demanded earlier was now waived. And in those early years after the union, the prospect of a credit default seemed distant. It is only now, since the default risk has loomed large, that yields on their bonds have risen and these economies have lost access to markets.

Borrowing per se is not bad; it is what is done with the borrowed money that matters. The countries that are currently in trouble did not use their borrowings to invest in productive assets. Had they done so, their export earnings would have increased and they would have had no trouble paying off their loans. Instead, in some countries the borrowings were used to fund consumption while in others foreign money fuelled a real estate boom.

Now that these countries are in trouble, the biggest disadvantage of a currency union — the loss of an independent monetary policy — has come to haunt them. In a currency union, monetary policy is decided in the interests of the powerful economies (in this case, Germany and France). Prior to the monetary union, these economies could have depended on a weaker currency to enhance their exports and pay off their debts. By joining the union, they have forfeited this option.

Restoring fiscal balance is more easily achieved through high growth rather than through spending cuts. The fiscal austerity that is being forced upon these nations (as a precondition for IMF and ECB assistance) will affect their growth, and only worsen their fiscal plight (as a lower level of economic activity translates into lower revenues for the government).

What remains to be seen is whether the currency union will survive the economic travails of its weaker members. Or will it unravel with some of the weaker economies reverting to their own currencies?